In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. Stocks and bonds are traded in "perfect markets," such that there are no transaction (or brokerage) costs and all corporate and individual investors can borrow and lend at the same rate of interest. The cost of debt increases with the level of debt. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Personal taxes offset the benefits derived by corporate taxes. A firm's earnings will grow at an unpredictable rate. Complete information is readily available to all investors and is free to all market participants. Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value. Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition 1)? study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. Stocks and bonds are traded in "perfect markets," such that there are no transaction (or brokerage) costs and all corporate and individual investors can borrow and lend at the same rate of interest. The cost of debt increases with the level of debt. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Personal taxes offset the benefits derived by corporate taxes. A firm's earnings will grow at an unpredictable rate. Complete information is readily available to all investors and is free to all market participants. DOO Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value. Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition 1)? Yes No Debt financing has one important advantage that the early Modigliani and Miller (MM) propositions ignored: the interest on business debt is tax deductible. This benefit means that the amount of taxes that a business is required to pay will be reduced by a phenomenon called an interest tax shield, which is a function of the amount of debt in the firm's capital structure and its tax rate. In contrast, the dividends that a corporation pays on its common and preferred shares are not tax deductible. Consider the case of Red Dolphin Foodstuffs, Inc.: At the beginning of the year, Red Dolphin Foodstuffs, Inc. had an unlevered value of $9,000,000. It pays federal and state taxes at the marginal rate of 30%, and currently has $3,500,000 in debt capital in its capital structure. According to MM Proposition I with taxes, Red Dolphin Foodstuffs is allowed to recognize a tax shield of and the levered value of the firm is: $12,500,000 $7,950,000 $10,050,000 $5,500,000 In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect business's use of debt financing, and developed the following model for the value of a levered firm: In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect business's use of debt financing, and developed the following model for the value of a levered firm: V = V + D [1 - (1 - Tc) (1 - Ts), (1 - Td) where, Tc, Ty, and to represent the tax rates imposed on corporate income, personal income from equity investments, and personal income from debt investments, respectively. A basic premise of Miller's work, under the current US Tax Code, is that investors are willing to accept a pre-tax return on equity investments than on bond investments because: Tax rates imposed on equity investments are lower than those imposed on bond investments. Tax rates imposed on bond investments are lower than those imposed on equity investments. The result of Miller's work is the conclusion that the US Tax Code produces two competing pressures that affect a business's use of leverage. These two conflicting effects are: -which creates a tax shield-favors the use of financing in a the deductibility of firm's capital structure. the preferential tax treatment of financing. income (dividends and capital gains) favors the use of In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. Stocks and bonds are traded in "perfect markets," such that there are no transaction (or brokerage) costs and all corporate and individual investors can borrow and lend at the same rate of interest. The cost of debt increases with the level of debt. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Personal taxes offset the benefits derived by corporate taxes. A firm's earnings will grow at an unpredictable rate. Complete information is readily available to all investors and is free to all market participants. Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value. Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition 1)? study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply. Stocks and bonds are traded in "perfect markets," such that there are no transaction (or brokerage) costs and all corporate and individual investors can borrow and lend at the same rate of interest. The cost of debt increases with the level of debt. All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT). Personal taxes offset the benefits derived by corporate taxes. A firm's earnings will grow at an unpredictable rate. Complete information is readily available to all investors and is free to all market participants. DOO Consider the following statement about a firm's capital structure: A firm's capital structure does not affect the firm's market value. Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition 1)? Yes No Debt financing has one important advantage that the early Modigliani and Miller (MM) propositions ignored: the interest on business debt is tax deductible. This benefit means that the amount of taxes that a business is required to pay will be reduced by a phenomenon called an interest tax shield, which is a function of the amount of debt in the firm's capital structure and its tax rate. In contrast, the dividends that a corporation pays on its common and preferred shares are not tax deductible. Consider the case of Red Dolphin Foodstuffs, Inc.: At the beginning of the year, Red Dolphin Foodstuffs, Inc. had an unlevered value of $9,000,000. It pays federal and state taxes at the marginal rate of 30%, and currently has $3,500,000 in debt capital in its capital structure. According to MM Proposition I with taxes, Red Dolphin Foodstuffs is allowed to recognize a tax shield of and the levered value of the firm is: $12,500,000 $7,950,000 $10,050,000 $5,500,000 In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect business's use of debt financing, and developed the following model for the value of a levered firm: In 1977, Merton Miller added to the discussion regarding the effect of taxes on a firm's value by including the effect of personal income taxes. He was interested in how the presence of individual income taxes would affect business's use of debt financing, and developed the following model for the value of a levered firm: V = V + D [1 - (1 - Tc) (1 - Ts), (1 - Td) where, Tc, Ty, and to represent the tax rates imposed on corporate income, personal income from equity investments, and personal income from debt investments, respectively. A basic premise of Miller's work, under the current US Tax Code, is that investors are willing to accept a pre-tax return on equity investments than on bond investments because: Tax rates imposed on equity investments are lower than those imposed on bond investments. Tax rates imposed on bond investments are lower than those imposed on equity investments. The result of Miller's work is the conclusion that the US Tax Code produces two competing pressures that affect a business's use of leverage. These two conflicting effects are: -which creates a tax shield-favors the use of financing in a the deductibility of firm's capital structure. the preferential tax treatment of financing. income (dividends and capital gains) favors the use of